Does Indonesia need Policy Tightening?

Speedy economic growth, together with massive credit increases and deteriorating current accounts have spurred fears among many analysts that Indonesia’s economy may be overheating, which may see the central bank of Indonesia being forced to increase interest rates.

Indonesia has seen a sharp deterioration in its current account position over the past year. However, this is largely explained by a slump in foreign demand rather than an unsustainable consumer boom driving up imports. Large inflows of foreign direct investment mean the country should have few problems sustaining a deficit over the medium term. While credit is growing rapidly at the moment, strong credit growth in part reflects a period of catch-up after a prolonged period of deleveraging which followed the Asian financial crisis. In addition, unlike in Hong Kong and Vietnam, there is little evidence that strong lending growth is fuelling asset price bubbles. Most new lending is being directed to productive sectors of the economy.

The recent performance of the economy has certainly been impressive. In 2011, GDP grew at its fastest pace since the Asian financial crisis (1997-98), and the strong growth has continued into the first half of this year. However, strong growth on its own does not mean the economy is overheating. To determine whether the current impressive expansion is sustainable, let’s look at four main indicators: the current account; credit growth,; inflation; as well as our estimates of trend growth.

There has been a sharp and sudden deterioration in Indonesia’s current account position, which has been in deficit for the past three quarters. However, while a current account deficit can sometimes be a symptom of overheating, this does not have to be the case. The worsening of the current account is not the result of an unsustainable consumer boom driving up imports. Instead it is due mainly to a sharp fall in exports, which is the result of weaker global growth and falling prices for the goods that Indonesia sells abroad.

As a low-income, fast-growing economy with plenty of opportunities to invest, it arguably makes sense for Indonesia to be importing capital from the rest of the world (in other words, running a current account deficit). Moreover, while a current account deficit can be a source of instability, this is unlikely to be the case in Indonesia. Unlike the last time Indonesia ran a current account deficit in 1997, the country is much less dependent on volatile portfolio inflows to fund the deficit. As a result, Indonesia is much less vulnerable to a balance of payments crisis than it was 15 years ago.

Another possible sign of overheating is rapid credit growth, which is now expanding by 25% y/y – one of the fastest rates of growth in the region. Strong credit growth which is sustained over a number of years is certainly something the authorities need to keep an eye on. Indeed, rapid credit growth was one of the main causes of both the Asian financial crisis, as well as the problems that Vietnam is now experiencing. Recent rapid credit growth in Indonesia in part reflects a period of catch-up after a prolonged period of deleveraging which followed the Asian financial crisis. Credit as a share of GDP in Indonesia actually fell from over 60% in 1997 to less than 20% in 2000. In 2011, credit in Indonesia was still the equivalent to only 30% of GDP, one of the lowest levels in the region. In addition, as an economy develops and the financial sector becomes more sophisticated, it is normal and healthy for credit to grow faster than nominal GDP.

As important to how quickly credit has been growing is where the new lending has been directed. There is little evidence that strong credit growth in Indonesia is fuelling asset price bubbles. Whereas places such as Hong Kong and Vietnam have seen a surge of lending into property, only 8% of bank lending in Indonesia has been into property-related sectors. As a result, while property prices have massively outstripped wage growth in Hong Kong, prices in Indonesia are increasing at a much slower pace than incomes. In addition, the stock market is also showing little sign of excess. Since the start of the year the Jakarta Composite has moved roughly in line with trends in the rest of the region. Moreover, the current price-earnings ratio of the Indonesian stock market is broadly in line with its long-run average.

Consumer price inflation was just 4.6% y/y in August, and is comfortably within Bank Indonesia’s (BI) central 3.5-5.5% target range. Admittedly, inflation is likely to rise before the end of the year due mainly to rising food prices which are being pushed higher by unfavourable base effects. A good harvest and the suspension of some import duties on food helped to suppress food prices last year. However, the any spike in inflation is likely to be temporary, and is not a sign of economic overheating. Core inflation, which is a better guide to underlying inflationary pressures, has been stable and is likely to remain low.

Indonesia’s economy grew by 6.5% in 2011. Despite the downturn in global demand, growth in Indonesia has barely slowed, with GDP expanding by 6.4% year-on-year in the first half of 2012. This compares with average growth since 2001 of just over 5%. This on its own is not evidence of overheating. Increased political stability and a rising investment rate have all helped to boost trend growth in Indonesia, which is now estimated to be around 6.5%. In addition, capacity utilisation in Indonesia is not unusually high, and is broadly in line with the average level of the last few years.

There also seems little danger of a wage-price spiral developing in Indonesia. Limitations with the data make it difficult to form firm conclusions, but wages appear to be increasing slowly. Meanwhile, a relatively high unemployment rate suggests there is still plenty of slack in the labour market.

Considering all of the evidence, it is rather unlikely that Indonesia’s economy is overheating. As a result there is little urgency for Bank Indonesia to tighten monetary policy. Indeed, given the poor outlook for global demand and the likelihood that the crisis in the euro-zone will worsen again soon, we believe interest rates in Indonesia will remain at their current record low level for the rest of this year and next. That being said, a further significant deterioration in the current account or a step-up in credit growth may see policy tightening.